One reason why people invest is to generate extra money. When investors sell that asset for more than what they paid, they come away with a profit, known as capital gains. The problem is that the capital gains will likely trigger a taxable event.
But are you on the hook for taxes if you reinvest that capital gain? The answer is yes in many cases: you pay taxes on reinvested capital gains. The tax rate depends on how long you held the asset and whether the capital gains are considered short-term or long-term:
- If you owned the asset for less than one year before selling, this is considered short-term. The gain is taxed as ordinary income.
- If you owned the asset for more than one year before selling, this is considered long-term. The profit is taxed as a capital gain.
In some cases, it’s possible to defer taxes through capital gains reinvestment using the following methods.
1031 Exchange
If you want to sell a real estate asset to replace it with a better one, a 1031 exchange could help defer capital gains taxes. The IRS keeps a close eye on the like-kind exchange process to ensure you meet the stringent deadlines and don’t have access to funds generated by the sale of your relinquished property. A Qualified Intermediary is required to oversee the relinquished and replacement property transactions and funds used for the exchange.
You could keep using the process to defer capital gains until your death. At that time, your heirs would receive the property with a step-up in basis (including deferred gains). This can mean your heirs won’t have to pay capital gains taxes on the sale of that property.
But the 1031 exchange can be used only for real estate for trade or investment purposes.
Qualified Opportunity Funds
Reinvesting your capital gains into a Qualified Opportunity Zone (QOZ) could also help defer taxes. A Qualified Opportunity Fund (QOF) targets economically distressed communities and funnels investors’ capital gains to help spur revitalization. Taxes on invested capital gains are deferred until Dec. 26, 2026. Like the 1031 exchange, QOF investments mean you must follow specific deadlines and guidelines to ensure the tax deferral status of your capital gains.
Retirement Accounts
If you keep your assets in a tax-advantaged retirement account, you can typically reinvest capital gains within that account without fear of triggering a taxable event. As long as funds or new assets remain in that account, the profits usually aren’t taxed. Remember that any withdrawals from that account are taxed at the ordinary income tax rates.
Taxes are Inevitable
While most investment goals are to generate wealth, that wealth will likely be taxed when you sell assets. It is possible to reduce or defer those taxes, however. As such, working with a financial advisor or tax specialist is your best bet to develop a tax-advantaged strategy that allows you to keep more of your wealth.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Investors in QOFs will need to hold their investments for certain time periods to receive the full QOZ Program tax benefits. A failure to do so may result in the potential tax benefits to the investor being reduced or eliminated.
If a fund fails to meet any of the qualification requirements to be considered a QOF, the anticipated QOZ Program tax benefits may be reduced or eliminated. Furthermore, a fund may fail to qualify as a QOF for non-tax reasons beyond its control, such as financing issues, zoning issues, disputes with co-investors, etc.
Distributions to investors in a QOF may result in a taxable gain to such investors.
The tax treatment of distributions to holders of interests in a QOF are uncertain, including whether distributions impact the aforementioned QOZ Program tax benefits.
A QOF must make investments in Qualified Opportunity Zones, which carries the inherent risk associated with investing in economically depressed areas.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
